RETIREMENT PLANNING

Retirement planning describes the financial strategies individuals employ
during their working years to ensure that they will be able to meet their
goals for financial security upon retirement. Making sound decisions about
retirement is particularly important for self-employed persons and small
business owners. Unlike employees of large companies, who can simply
participate in the pension plans and investment programs offered by their
employers, entrepreneurs must set up and administer their own plans for
themselves and for their employees.

Though establishing and funding retirement plans can be costly for small
businesses, such programs also offer a number of advantages. In most
cases, for example, employer contributions to retirement plans are tax
deductible expenses. In addition, offering employees a comprehensive
retirement plan can help small businesses attract and retain qualified
people who might otherwise seek the security of working for a larger
company. The number of small firms establishing retirement plans grew
during the 1990s, but small employers still lag far behind larger ones in
providing this type of benefit for employees. According to
Connecticut-based consulting firm Access Research Inc., 24 percent of
small businesses (those with fewer than 100 employees) offered retirement
plans in 1996, compared to 51 percent of medium-sized businesses (between
100 and 1,000 employees) and 98 percent of large businesses (more than
1,000 employees).

Retirement planning is a topic of interest not only to older small
business owners, but to young entrepreneurs as well. The debate over
whether Social Security will be available for the younger members of the
current work force adds legitimacy to the need for early retirement
planning. Longer life expectancies mean that more money must be set aside
for retirement, while the uncertainty of investment returns and inflation
rates makes careful planning essential. In fact, some experts recommend
that individuals invest a minimum of 10 percent of their gross income from
the time they enter the work force to guarantee a comfortable retirement.

LAWS GOVERNING RETIREMENT PLANS

The Social Security Administration was created in the 1930s as part of
President Franklin Roosevelt's New Deal. Private pension plans
mushroomed shortly thereafter, offering coverage to millions of employees.
In 1962 the Self-Employed Individuals Retirement Act established
tax-deferred retirement plans with withdrawals starting between the ages
of 59
1
⁄
2
and 70
1
⁄
2
. These plans—also known as Keogh plans after their originator, New
York Congressman Eugene J. Keogh—were intended for the
self-employed and for those who have income from self-employment on the
side. Embezzlement from pension plans by trustees led to the passage of
the Employee Retirement Income Security Act of 1974 (ERISA). One of the
main provisions of ERISA was to set forth vesting requirements—time
periods over which employees gain full rights to the money invested by
employers on their behalf. ERISA governs most large-employer sponsored
pension plans, but does not apply to those sponsored by businesses with
less than 25 employees.

TYPES OF RETIREMENT PLANS

The two main categories of retirement plans are defined contribution and
defined benefit. Defined contribution plans use an allocation formula to
specify a percentage of compensation to be contributed by each
participant. For example, an individual can voluntarily deduct a certain
portion of his or her salary, in many cases before taxes, and place the
money into a qualified retirement plan, where it will grow tax-deferred.
Likewise, an employer can contribute a percentage of each
employee's salary to the plan on their behalf, or match the
contributions employees make.

In contrast, defined benefit plans calculate a desired level of benefits
to be paid upon retirement—using a fixed monthly payment or a
percentage of compensation—and then the employer contributes to the
plan annually according to a formula so that the benefits will be
available when needed. The amount of annual contributions is determined by
an actuary, based upon the age, salary levels, and years of service of
employees, as well as prevailing interest and inflation rates. In defined
benefit plans, the employer bears the risk of providing a specified level
of benefits to employees when they retire. This is the traditional idea of
a "pension plan" that has often been used by large employers
with a unionized work force. But defined benefit plans can also be useful
for small business owners who are nearing retirement age and wish to put
away as much money as possible.

Perhaps the most significant difference between defined benefit and
defined contribution plans is the voluntary nature of defined contribution
plans. Such plans are fully voluntary, so that hourly or salaried
employees elect to have a certain percentage of money
deducted—before taxes—from their paychecks. Conversely,
defined benefit plans involve automatic contributions made by the
employer, with no active participation on the part of the employee.

In the 1980s, defined benefit plans declined in popularity in favor of
defined contribution plans. Part of this decline can be attributed to the
fact that the work force became more mobile, and fewer people were willing
to commit their entire working lives to a single employer in order to gain
a pension. Employers, too, began moving away from defined benefit plans
because of the financial pressure involved in funding them. Such pressure
increased for some categories of employers in 1996, when nondiscrimination
rules took effect. These rules state that public sponsors must offer the
same benefits to all employees regardless of their compensation. Many
state and local municipalities have moved to defined contribution plans to
avoid this new mandate.

One significant advantage of defined contribution plans is that the amount
invested by employees can be rolled over into another account with another
employer. Rollover activity into similar tax-deferred plans has continued
to increase as tax laws require a 20 percent withholding tax to be paid on
the lump sum if it is not rolled over. Another reason for the growth of
defined contribution plans was the emergence of 401(k) plans, in which
employers can match contributions made by employees. But defined
contribution plans continued to face scrutiny by many financial advisers
for two reasons:1) the investment decisions made by the company may be too
restrictive for employees to meet individual goals; and 2) many times
employees are not educated about the risk and returns associated with the
investment vehicles available through the company plan. Similarly, the
voluntary nature of defined contribution plans makes detractors wonder if
ill-informed employees will have less money in their defined contribution
accounts at retirement than they would have had under a defined benefit
plan.

OPTIONS FOR SMALL BUSINESSES

Small business owners can set up a wide variety of retirement plans by
filling out the necessary forms at any financial institution (a bank,
mutual fund, insurance company, brokerage firm, etc.). The fees vary
depending on the plan's complexity and the number of participants.
Some employer-sponsored plans are required to file Form 5500 annually to
disclose plan activities to the IRS. The preparation and filing of this
complicated document can increase the administrative costs associated with
a plan, as the business owner may require help from a tax advisor or plan
administration professional. In addition, all the information reported on
Form 5500 is open to public inspection.

The most important thing to remember is that a small business owner who
wants to establish a qualified plan for him or herself must also include
all other company employees who meet minimum participation standards. As
an employer, the small business owner can establish retirement plans like
any other business. As an employee, the small business owner can then make
contributions to the plan he or she has established in order to set aside
tax-deferred funds for retirement, like any other employee. The difference
is that a small business owner must include all nonowner employees in any
company-sponsored retirement plans and make equivalent contributions to
their accounts. Unfortunately, this requirement has the effect of reducing
the allowable contributions that the owner of a proprietorship or
partnership can make on his or her own behalf.

For self-employed individuals, contributions to a retirement plan are
based upon the net earnings of their business. The net earnings consist of
the company's gross income less deductions for business expenses,
salaries paid to nonowner employees, the employer's 50 percent of
the Social Security tax, and—significantly—the
employer's contribution to retirement plans on behalf of employees.
Therefore, rather than receiving pre-tax contributions to the retirement
account as a percentage of gross salary, like nonowner employees, the
small business owner receives contributions as a smaller percentage of net
earnings. Employing other people thus detracts from the owner's
ability to build up a sizeable before-tax retirement account of his or her
own. For this reason, some experts recommend that the owners of
proprietorships and partnerships who sponsor plans for their employees
supplement their own retirement funds through a personal after-tax savings
plan.

Nevertheless, many small businesses sponsor retirement plans in order to
gain tax advantages and increase the loyalty of employees. A number of
different types of plans are available. The most popular plans for small
businesses all fall under the category of defined contribution plans. In
nearly every case, withdrawals made before the age of 59
1
⁄
2
are subject to an IRS penalty in addition to ordinary income tax. The
plans differ in terms of administrative costs, eligibility requirements,
employee participation, degree of discretion in making contributions, and
amount of allowable contributions. Brief descriptions of some of the most
common types of plans follow:

SIMPLIFIED EMPLOYEE PENSION (SEP)PLANS
SEP plans are employer-funded retirement accounts that allow small
businesses to direct at least 3 percent and up to 15 percent of each
employee's annual salary, to a maximum of $30,000, into
tax-deferred individual retirement accounts (IRAs) on a discretionary
basis. SEP plans are easy to set up and inexpensive to administer, as the
employer simply makes contributions to IRAs that are established by
employees. The employees then take responsibility for making investment
decisions regarding their own IRAs. Employers thus avoid the risk and cost
involved in accounting for employee retirement funds. In addition,
employers have the flexibility to make large percentage contributions
during good financial years, and to reduce contributions during hard
times. SEP plans are available to all types of business entities,
including proprietorships, partnerships, and corporations. In general,
eligibility is limited to employees 21 or older with at least three years
of service to the company and a minimum level of compensation. The maximum
level of compensation for SEP eligibility is $170,000.

SAVINGS INCENTIVE MATCHPLAN FOR EMPLOYEES (SIMPLE)
SIMPLE plans take two forms: a SIMPLE IRA and a SIMPLE 401(k). Both plans
became available in January 1997 to businesses with less than 100
employees, replacing the discontinued Salary Reduction Simplified Employee
Pension (SARSEP) plans. They were intended to provide an easy, low-cost
way for small businesses and their employees to contribute jointly to
tax-deferred retirement accounts. An IRA or 401(k) set up as a SIMPLE
account requires the employer to match up to 3 percent of an
employee's annual salary, up to $6,000 per year. Employees are also
allowed to contribute up to $6,000 annually to their own accounts.
Companies that establish SIMPLEs are not allowed to offer any other type
of retirement plan. As of early 1997, most small businesses chose the
SIMPLE IRA option, as the SIMPLE 401(k) proved more expensive than a
regular 401(k) due to the company matching requirements. The main problem
with the plans, according to Stephen Blakely in
Nation's Business,
was that "Congress is already drafting legislation that would make
SIMPLE less simple and more costly for the very businesses the plans were
created to serve."

PROFIT SHARING PLANS
Profit sharing plans enable employers to make a discretionary, tax
deductible contribution on behalf of employees each year, based on the
level of profits achieved by the business. The total annual contribution
is generally allocated among employees as a percentage of their
compensation. Plan costs are tax deductible for the employer, and plan
earnings are tax deferred for employees. Profit sharing plans are easy to
implement, offer design flexibility, and provide a wide range of
investment choices. Eligibility is typically limited to employees who are
at least 21 years of age and who have at least one year of service. The
employer's maximum deduction is 15 percent of the total annual
salaries paid to nonowner employees (adjusted to 13.04 percent for the
small business owner).

A common variation is the age-based profit sharing plan, in which
contributions are based on an
allocation formula that factors in the age or number of years to
retirement of participants. Age-based profit sharing allows employers to
reward valued older employees for their length of service. Another
variation is the new comparability profit sharing plan, which allows
employers to define classes of employees and set up the retirement plan so
that certain classes benefit the most in terms of allocation. These types
of profit sharing plans are similar to defined benefit plans, but the
employer contributions are discretionary.

MONEY PURCHASE PENSION PLANS
Money purchase pension plans are similar to regular profit sharing plans,
but the employer contributions are mandatory rather than discretionary.
The main advantage of money purchase plans is that they allow larger
employer contributions than regular profit sharing plans. The employer
determines a fixed percentage of profits that will be allocated to
employee retirement accounts according to a formula. The maximum employer
contribution jumps to 25 percent of payroll for nonowner employees
(adjusted to 20 percent for the small business owner) or a total of
$30,000 per employee. There are also combination money purchase-profit
sharing plans that allow employers to select a fixed percentage for
mandatory contribution and also retain the option of contributing
additional funds on a discretionary basis when cash flow permits.

401(K) PROFIT SHARING PLANS
The popular 401(k) plans are profit sharing plans that include a
provision for employees to defer part of their salaries for retirement.
The employer can make annual profit sharing contributions on behalf of
employees, the employees can contribute up to $10,000 of pre-tax income
themselves, and the employer can choose to match some portion of employee
contributions. 401(k) plans offer a number of advantages. First, they
allow both employer and employee to make contributions and gain tax
advantages. Second, they can be set up in such a way that employees can
borrow money from the plan. Third, 401(k) plans enable employees to become
active participants in saving and investing for their retirement, which
raises the level of perceived benefits provided by the employer. The main
disadvantages are relatively high set up and administrative costs.
Eligibility for 401(k) plans is typically limited to employees at least 21
years of age who have at least one year of service with the company.

Small businesses that establish 401(k)s must be careful to avoid liability
for losses employees might suffer due to fluctuations in the value of plan
investments. Under ERISA, plan sponsors can avoid liability by ensuring
that their 401(k) meets three criteria: offering a broad range of
investment options to employees; communicating sufficient financial
information to employees; and allowing employees to exercise independent
control over their accounts.

WHICH PLAN TO CHOOSE

Small business owners must carefully examine their priorities when
selecting a retirement plan for themselves and their employees. If the
main priority is to minimize administrative costs, a SEP plan may be the
best choice. If it is important to have the flexibility of discretionary
contributions, a profit sharing plan might be the answer. A money purchase
plan would enable a small business owner to maximize contributions, but it
would require an assurance of stable income, since contributions are
mandatory. If the small business counts upon key older employees, an
age-based profit sharing plan or a defined benefit plan would help reward
and retain them. Conversely, an employer with a long time horizon until
retirement would probably do best with a defined contribution plan.
Finally, a small business owner who wants employees to be able to fund
part of their own retirement should select a SIMPLE or a 401(k) plan.
There are also many possibilities for combination plans that might provide
a closer fit with a small business's goals. Free information on
retirement plans is available through the Department of Labor or on the
Internet at
www.dol.gov
.

FURTHER READING:

Blakely, Stephen. "Pension Power."
Nation's Business.
July 1997.

Clifford, Lee. "Getting Over the Hump before You're Over the
Hill."
Fortune.
August 14, 2000.